Obama + Ryan = Catastrophe

Between Democratic President Barack Obama and Republican House Budget Committee Chair Paul Ryan, it appears that one way or another we are facing big budget cuts. In fact, this process has already started. I addressed at length the folly, even insanity, of this policy in a previous article here at Forbes.com:

But the issue is sufficiently important to warrant another post–hell, another ten, if necessary. We are in the midst of committing national economic suicide and there is absolutely no reason for it. In point of fact:

the federal government’s budget is not analogous to a private one;

the federal budget doesn’t ever have to balance;

deficits generate higher levels of economic activity than would otherwise be possible; and

China doesn’t own the United States regardless of how many Treasury Bills they have.

However, as all that is covered in the article linked above, I wont’ go over it again here. Instead, let me frame the issue in a slightly different manner. It’s called the sectoral balances approach and anyone can understand it fairly quickly. What it will show is that federal government surpluses suck wealth out of the private sector.

Say that our entire economy is composed of two people: Alex and Meg. They work, produce output, earn incomes, spend, etc. Say further that there are no government or foreign sectors. It’s just Alex and Meg.

Notice something: their total spending must also be equal to their total income. How can they spend money in a manner that it does not become somebody else’s income, and how can they earn income except as a result of the another’s spending? This is actually true in any macroeconomic unit, whether it is two people or 200 million. It’s just easier to see in the former case.

Now here’s a corollary to this simple economic identity: whenever Alex spends more than she earns, Meg earns more than she spends. When Alex is in deficit, Meg is in surplus; and when Alex is in surplus, Meg is in deficit. This is a very basic lesson often taught in introductory finance courses and it easily extends to a more complex system. It basically says that the sum total of all deficit spending in an economic system is exactly equal to the total of all surpluses.

To see how this works, imagine the following conditions. Assume a financial system that allows Alex to borrow $10,000. Also allow Meg and Alex to buy output made by their own factories. Were this not the case, one’s income would always be identical to the other’s spending, which is not necessary in the real world when Meg and Alex are entire sectors of the economy (and can therefore have internal transactions–people who work at the pretzel factory can buy pretzels):

INCOME

Alex: $50,000

Meg: $40,000

Total: $90,000 (remember that this must be equal to total spending!!!)

SPENDING

Alex: $60,000

Meg: $30,000

Total: $90,000 (remember that this must be equal to total income!!!)

SPENDING MINUS INCOME

Alex: -$10,000 (deficit)

Meg: +$10,000 (surplus)

Total: $0

Meg’s financial wealth has increased by $10,000. She earned $40,000 and spent $30,000, so must have the rest in financial assets and cash. Meanwhile, Alex is $10,000 in debt. And it always works this way. Since spending and income must logically be the same number, there is no way for one person’s deficit not to be exactly equal in magnitude to the other person’s surplus. It’s impossible. Try plugging in other numbers while holding to that rule and you’ll see what I mean.

Now change “Alex” to the “US federal government” and “Meg” to the “private sector” and note this critical fact: whenever the government spends in deficit, private sector wealth increases; and when the government runs a surplus, private sector wealth declines. That’s not a trick, it’s simple arithmetic. Government surpluses suck wealth out of the market. Of course they do, because they represent really high taxes relative to government spending. That’s like the US private sector having a trade deficit with respect to its own government. We become increasingly indebted to them.

This is what Obama and Ryan are trying to accomplish today. They call it budget balancing, but what if we labeled it “private sector wealth destruction?” “Budget balancing” has a very positive, responsible ring to it and thus at a gut level we are all in favor of it. It just has to be a good thing, doesn’t it? But would we be rushing to embrace “private sector wealth destruction?” Of course not. To be sure, what Obama and Ryan are talking about at first are only smaller deficits and not surpluses per se, but a) reducing the debt will eventually require surpluses and b) a sector I left out for simplicity, the foreign one, is also currently in surplus (for us this means a trade deficit), which also reduces private sector wealth. In other words, if we have a balanced budget for the federal government at the same time foreigners have a surplus, this means a net deficit for private citizens and firms–wealth destruction.

Of course, if there is some benefit that accompanies this cost then perhaps it’s worth it. Maybe the private sector wealth destruction also creates a positive that eventually dominates and makes us all better off. The most common view coming from this perspective is that we have to reduce spending because it is financially prudent to do so. Otherwise, we will face default, an increased future tax burden, etc. As I addressed, and dismissed, these at length in an earlier Forbes.com piece (linked above), I will not do so again here. Suffice it to say that the federal government cannot go bankrupt in debt it owes in dollars. It can choose to do so (in the same way that a person in a warehouse full of food can choose to starve to death), but there is no logical reason for it. The fear of default is based on a flawed understanding of the way the federal budget works.

The second most common argument is that reducing government spending will create economic growth, that the current size of the public sector is holding the private sector in check. If only we could reduce the size of deficit, then the market would explode with growth and new jobs.

Consider first why entrepreneurs expand operations. They produce more output and hire additional workers when they expect higher sales. Stores at the mall do this before Christmas, amusement parks do this before summer, and tax preparation services do this before April 15. Costs are important to firms, too, but they are generally a distant second to sales. Interest rates, for example, couldn’t possibly get any lower than they are now, yet this is hardly causing an explosion of economic activity. Workers, too, are cheap and easy to find because of our high unemployment rate. Apparently, however, this isn’t sufficient.

Returning to the Obama/Ryan budgets, there are two ways for them to reduce the deficit: lower spending or raise taxes. Which one of those is likely to get entrepreneurs all excited about the prospect of future sales: a decrease in the incomes of their public sector customers or a rise in the general tax burden? Neither one, obviously. In fact, it is far more likely to lead to even further contraction and, ironically, an even larger budget deficit as tax revenues fall and government payments for unemployment and income support programs rise–an unintended consequence to say the least.

Along similar lines, there are those who argue that government sector spending crowds out the private sector and that as we reduce the former, so the latter will fill the gap. What you have to understand is that the logic of those models is based on the idea that we are already at full employment, that there aren’t any unemployed laborers available who could come to work for your business unless the government laid some off. Right now, there are around 13.5 million unemployed workers, so no worries there and no crowding out. In summary, the arguments that lowering spending and/raising taxes will boost the private sector are false.

This has to be one of the easiest economic forecasts in history. If Obama and especially Ryan have their way, economic catastrophe will result. The idea that the economy will benefit from lowering incomes or raising taxes is so foolish that it is difficult to imagine that anyone is embracing it for anything other than ideological reasons. It’s not as if we are on unfamiliar ground here, either. At the height of the Great Depression, unemployment hit almost 25% (can you even begin to imagine that, particularly in a world without the social support mechanisms we have now?). By 1936, we had lowered it to 14%. However, just as now, people began to assume that the economy was well on its way to recovery and started making calls for budget balancing. These were heeded and, as a consequence, unemployment jumped back up to 19%. It took three more years go get it back to 14%, and WWII to truly raise government spending to the levels necessary to address the problem. The war caused debt to eventually rise to the point that it was 120% of GDP, well above today’s 60% (the latter according to the CIA, though I’ve seen estimates 10 to 20 points higher). The period following the war was hardly one of default and stagnation. In fact, it was happy days.